How Forward Contracts Help Businesses Hedge Against Price Fluctuations?

The prices of commodities, whether it’s crude oil, food grains, or metals, are constantly fluctuating. The price of a barrel of crude oil, for example, could be $50 today, rise to $65 next month, or drop to $30 a month later. These fluctuations create a lot of uncertainty for businesses that rely on such commodities.

Apart from uncertainty, these price movements often trigger a lot of speculation. Companies that trade in commodities frequently aim to benefit from these shifting prices by using a financial tool called a “forward contract.” This contract helps them buy or sell commodities at a predetermined price on a future date, helping them manage the risk of price changes.

What is a Forward Contract?

A forward contract is a type of financial agreement between two parties. It allows one party to agree to buy, and the other party to sell, a particular commodity at a fixed price on a future date. The contract is customized and negotiated privately, meaning it doesn’t have to follow any specific set of rules from external regulators or exchanges. Because of this, forward contracts are considered “over-the-counter” (OTC) agreements.

Businesses use forward contracts as a way to hedge or protect their investments from unexpected price swings. While they can also be used for speculation (trying to make a profit from guessing future prices), forward contracts are more commonly used for reducing financial risk.

How Forward Contracts Work?

Forward contracts can be used in various ways depending on the specific needs of a business:

• Rolling hedge: A rolling hedge allows a company to repeatedly enter forward contracts, protecting themselves over multiple time periods.
• Open forward contracts: These flexible contracts give the parties some freedom in choosing when to settle, within an agreed time frame.
• Market orders: Forward contracts can also be used with market orders to ensure that the deal gets executed when certain market conditions are met.

Key Features of a Forward Contract

Here are some key characteristics of a forward contract:

• No central exchange: Unlike other financial contracts that trade on stock exchanges, forward contracts are traded privately between two parties.
• Counterparty risk: Since the contract isn’t regulated, there’s a chance that one party might not fulfill their obligation, creating a risk for the other.
• Custom terms: The two parties can decide on all the terms of the contract, such as the expiration date, asset quantity, and price.
• Non-public information: Details about forward contracts aren’t available to the public, meaning that the general public cannot see or access the contract price or other terms.

Currency Forward Contracts

A currency forward contract is a type of forward contract in which two parties agree to exchange one currency for another on a future date at a predetermined rate. For example, if a company in the UK buys goods from a company in the USA, they may agree to pay for the goods in U.S. dollars. However, because exchange rates fluctuate, the UK company might want to lock in a specific exchange rate using a currency forward contract. This protects them from any future changes in the exchange rate.

Example: A UK-based company imports goods worth 1 million euros from a U.S. company, which expects to receive $1.2 million within 90 days. To avoid the risk of currency fluctuations, the U.S. company might enter into a forward contract with a bank to lock in the current exchange rate, securing their profit despite market changes.

How Does an FX (Foreign Exchange) Forward Contract Work?

An FX forward contract involves two parties agreeing to exchange different currencies on a specified future date. This helps companies hedge their foreign exchange risks and ensures they are protected from potential swings in exchange rates.

Example of a Forward Contract in Action

Let’s take an example from the agricultural sector. A beverage company may enter a forward contract with a coffee estate to purchase 10,000 kg of coffee beans in three months. At the time of signing, the market price of coffee beans is INR 500/kg. However, the coffee estate fears that prices might drop in the coming months. So, they agree to sell the beans at INR 480/kg in three months through a forward contract. This guarantees the coffee estate a certain income, regardless of market price changes.

When the contract expires, three possible outcomes can occur:

• Market price falls below the contract price: The beverage company pays more than the current market price, but the coffee estate avoids losses.
• Market price rises above the contract price: The coffee estate misses out on higher profits, but the beverage company benefits.
• Market price matches the contract price: Neither party gains or loses.

Hedging vs. Speculation in Forward Contracts

Speculation

This involves trying to predict market movements and make profits from price changes. It’s a high-risk approach that involves betting on future price trends.

Hedging

Companies typically use forward contracts for hedging, which is a strategy to reduce risk. Hedging helps businesses protect themselves against price fluctuations in the commodities they deal with. It’s a safer, more conservative approach than speculation.

How Forward Contracts Help in Export Hedging?

Exporters and importers often face the risk of fluctuating exchange rates, especially when there’s a significant gap between signing a contract and receiving payment. Forward contracts can help both parties manage this risk by locking in an exchange rate, ensuring that neither side is negatively affected by currency volatility.

Valuing a Forward Contract

The price or value of a forward contract, often called the “forward rate,” is calculated by adding or subtracting “forward points” to or from the spot rate (the current price). Forward points depend on the difference in interest rates between the two currencies involved in the deal. Forward points represent a tiny fraction (0.0001) of the spot rate.

Types of Forward Contracts

• Closed Outright Forward: The simplest type of forward contract, where both parties agree to exchange currencies on a future date at a fixed price.
• Flexible Forward: This allows parties to make partial exchanges before the final settlement date, giving them more flexibility in fulfilling the contract.
• Long-Dated Forward: While most forward contracts are short-term, a long-dated forward extends beyond one year.
• Non-Deliverable Forward: In this type of contract, parties exchange the difference between the agreed-upon contract price and the actual market price at maturity, without physically exchanging the commodity or currency.

Advantages of Forward Contracts

• Highly customizable: Parties can tailor the terms of the contract to suit their specific needs.
• Hedging tool: Forward contracts help companies hedge against market price fluctuations.
• Reduces risk in international trade: By locking in prices, companies can manage exchange rate risks more effectively.
• No upfront costs: There are typically no additional costs for entering into a forward contract.

Risks or Limitations of Forward Contracts

• Lack of transparency: Since these contracts aren’t publicly traded, there is little public information about them.
• Counterparty risk: The risk of one party defaulting on the contract is a concern, as forward contracts aren’t regulated.
• Volatility risk: In highly volatile markets, forward contracts can lead to losses if the parties miscalculate future price movements.

Forward Contracts vs. Futures Contracts

Both forward and futures contracts allow parties to buy or sell commodities at a future date, but there are key differences:

• Forward contracts are customized, private agreements between two parties.
• Futures contracts are standardized agreements traded on exchanges and regulated by third parties.

Forward Contracts vs. Spot Contracts

• A spot contract refers to a transaction where the asset is purchased and delivered immediately at the current market price. 
• In contrast, a forward contract involves buying or selling an asset at a predetermined price, but on a future date. Forward contracts are ideal for companies looking to lock in current prices for future transactions.

Frequently Asked Questions (FAQs)

Also Read: Understanding Forex Hedge as a Currency Hedging Strategy for Exporters